Updated July 25, 2023
What is Tax Shelter?
A tax shelter is more or less like a financial vehicle through which taxpayers can safeguard their money. In other words, it is a type of legal strategy with the help of which an individual can lower their taxable income and hence reduce his or her tax-related liabilities.
It can be understood as a financial vehicle or legal strategy or any method applied with a full conscience for the purpose of minimizing taxable income, which would ultimately lower the tax liabilities of a taxpayer. It is also a method through which a person or a company can arrange their finances in a manner that helps them in reducing their tax burden.
Types of Tax Shelters
There are mainly two types available which include the following:
- Legitimate Tax Shelter: Using this shelter, a person generally generates income. For example, retirement accounts.
- Abusive Tax Shelter: Using this shelter, a person only saves its money from the tax, which generally does not generate income.
Effects of Tax Shelter
From an individual or company’s point of view, tax shelters are beneficial without any doubt. They can have positive effects on society too. This can be because of the fact that for a few large beneficial tax shelters, erosion of its tax base could be a minute or an acceptable loss. This is possible in the case of charitable contributions. However, certain tax shelters are not at all harmful or have social benefits at all.
How Does Tax Shelters Work?
These work by offsetting the income and simultaneously minimizing the tax burden of a taxpayer. Losses suffered on investments that are tax-sheltered can also help in minimizing taxable income. Enhancing itemized deductions can help a taxpayer in sheltering or minimizing his tax liabilities. Conversion of ordinary gains that are 100 percent taxable to gains that are less than 100 percent taxable is also a way in which tax-shelter actually works.
- One of the examples of tax shelter can be seen in the case of Home equity. It is the financial value of a residential property that the buyer of the home owns fully free and without any debt.
- Another example includes 401(K) accounts. They are temporary. A taxpayer pays pre-tax income into his or her 401(K) account to minimize his tax liabilities.
Using Deductions as a Tax Shelter
Spending money can also help save some money, which holds true if one is willing to use deductions in tax shelters. In a real sense, it means buying certain goods that offer tax benefits, and in this way, the money that is spent will be partially recovered by means of tax reductions or tax credits.
Using Retirement Accounts
Tax-deferred retirement accounts are also a type of tax shelter. These retirement accounts are temporary tax shelters. When a taxpayer makes a contribution to a deductible traditional IRA or a 401(K), his or her taxable income gets lowered to the extent of his or her contribution. The taxpayer’s money becomes tax-deferred, which also means that the same shall be capable of accruing interest and earnings on it that are supposedly not taxed every year. A tax-deferred retirement account is temporary as the taxpayer will have to pay compulsory taxes on that money in the future. IRS shall start collecting income tax once the taxpayer will start receiving distributions in his or her retirement.
Using Home Equity as a Tax Shelter
Home equity has a tendency to increase the net worth of an individual. This is one of the prime reasons why the purchase of a home is an important milestone for any individual. Paying a home mortgage could be financially liberating, but if the owner doesn’t sell the house property, then he or she will not be able to derive the benefits of his home equity unless he or she opts for a home equity loan.
Difference Between Tax Shelter and Tax Evasion
Tax shelters can also be used for the purpose of evading taxes apart from legally minimizing tax liability. Tax avoidance (also known as tax minimization) is a legal way to minimize taxable income and reduce the tax burden. Tax shelter and tax evasion are totally different concepts, and the two must not be confused with one another since the former is a legal procedure while the latter is illegal. Making an investment solely for the purpose of evading taxes can put the taxpayer in a state where he or she will be bound to pay fines and penalties.
For example, entities that opt for illegal practices where they create offshore companies to evade taxes for availing the benefits of favorable tax rates in different countries are going to be heavily fined by the IRS. As per IRS, such activities are fraudulent and need to be discouraged by punishing the culprit with fines, penalties, prison sentences, and criminal prosecution.
Advantages and Disadvantages
It can help in minimizing the tax burden of a taxpayer by minimizing his or her taxable income. The best thing is that these are totally legal and legitimate methods that a taxpayer can use for minimizing his or her tax liability. Though tax systems are a legal and safe way of minimizing tax burden, the same can also be used for wrong purposes, such as evasion of taxes. Evading taxes can even lead the taxpayer in trouble if at he or she is caught by the IRS. In such cases, the accused, if found and proven guilty, will be entitled to pay fines or can even be charged with criminal prosecution and might also be imprisoned.
Tax shelters are methods through which individuals and enterprises minimize their tax liabilities. Tax shelter ranges from 401(K) programs to international bank accounts. There are numerous legitimate at the moment. Instead of opting for increasingly obscure methods of limiting tax liability, the taxpayers must try and stick to tactics that are tried and tested, such as saving for retirement or children’s college admission fees, investment in real estate properties, etc.
This is a guide to Tax Shelter. Here we discuss the difference between tax shelter and tax evasion, along with types and examples. You may also look at the following articles to learn more –